In a surprising move, the Federal Reserve has initiated a new phase of monetary policy easing by slashing interest rates by 50 basis points. This aggressive action brings the Fed funds rate down to the 4.75-5% range, marking an end to the era of aggressive rate hikes aimed at taming persistent inflation. The Fed has also signaled two more rate cuts this year, aiming to bring the Fed funds rate down to 4.4% in 2024.
The markets reacted with a mix of caution and optimism following the announcement. While all three major indexes closed in the red on Wednesday, the banking sector saw positive gains. The KBW Nasdaq Bank Index and the S&P Banks Select Industry Index closed in green, reflecting the potential benefits of lower interest rates for banks.
This rate cut is a welcome development for major banks like Bank of America, Citigroup, and Comerica. These institutions have been facing significant pressure from rising funding costs, which have offset the gains from higher interest income. As interest rates come down, funding costs are expected to gradually stabilize and even decline, easing pressure on net interest margins. However, JPMorgan Chase anticipates a potential decrease in its net interest income next year, a trend they attribute to anticipated rate cuts.
Beyond this year’s rate cuts, the Fed’s dot plot indicates further reductions in the future. They project four more rate cuts in 2025 and two in 2026, bringing the interest rates close to 2.9% by the end of 2026, lower than the 3.1% forecasted during the June FOMC meeting.
The latest Summary of Economic Projections (SEP) indicates that the US economy is expected to grow at a 2% rate until 2026. However, the Fed officials acknowledged a slowdown in job gains and a rise in the unemployment rate, which remains low. They revised their expected unemployment rate for 2024 to 4.4%, up from the 4% forecast in June. Additionally, the inflation target has been lowered to 2.3% for 2024, down from 2.6% predicted in June.
Beyond the impact on funding costs, lower interest rates are likely to stimulate loan demand. The lending scenario has been muted since the Fed began tightening its monetary policy in March 2022, negatively impacting bank financials. As rates decline, borrowers who have been hesitant due to higher rates are expected to re-enter the market, leading to an increase in loan demand. This surge in lending activity could benefit banks like Bank of America, Citigroup, JPMorgan Chase, and Comerica.
Lower interest rates also have the potential to improve banks’ asset quality as borrowers become more likely to repay their loans. However, it’s important to note that these positive impacts are not expected to be immediate, and investors should not anticipate a complete turnaround in bank financials, at least in the near term.
